2021 Solution Exam 1
2021 Solution Exam 1
2021 Solution Exam 1
a. The Arrow-Debreu equilibrium is a consumption allocation {{cit (st )}∞ t=0 }i=1,2
0 ∞
and a price system {qt }t=0 such that 1) given the price system, the allocation
solves each consumer’s problem;
P2 2) the allocation is feasible, ie it satisfies the
aggregate resource constraint i=1 ct (s ) ≤ 1 for all t and all st . [0.5 points]
i t
Therefore,
∞
c1 XX
= β t Prob(st |s0 )(1 − st )
1−β t=0 t s
or
" ∞
#
1
X
t β 3−β
c = (1 − β) 1/2 + β (1/3 × 1 + 2/3 × 0) = (1 − β) 1/2 + = .
t=1
3(1 − β) 6
3+β
c2 = 1 − c1 = . [0.5 points]
6
1
c. From the previous question we deduce
Consumer 1 enters period 1 with negative financial wealth. This means she
owes to consumer 2. She is lucky to have landed in a good state, but must now
deliver the goods she promised in period 0, at the time when the world was un-
certain and she was eager to buy securities to insure against the future. Given
that her wealth is negative, she cannot buy more claims to future consumption
without giving up on consumption in other periods, thus harming her perfectly
smoothed consumption plan. Therefore, even if markets reopened, it would not
be in her interest to trade. [0.5 points]
a. The household maximizes utility subject to the resource constraint and the
capital accumulation equation. Combine the two constraints
Ct = (1 + r)Kt + zt − Kt+1 .
2
Let K̃ and z̃ be the value of capital and productivity tomorrow. Plug the resource
constraint into the utility function and write a Bellman equation [0.5 points]
h i2
V (K, z) = max (1 + r)K + z − K̃ − λ (1 + r)K + z − K̃ + βEV (K̃, z̃) .
K̃
b. The first-order condition with respect to K̃ and the envelope theorem are
Combine the two necessary conditions and obtain the Euler equation
In order for this equation to hold, we need the coefficients on Kt and zt and the
constant term to be the same on both sides. Equating the coefficients on Kt
yields
B = B(1 + r − B) or B = r.
Equating the coefficients on zt yields
B
D = B + D(ρ − B) or D= .
1−ρ+B
A = A(1 − B).
3
Provided that B = r 6= 1, we need A = 0. We are ignoring the case where B = 0
and D = 0 with no restriction on A. [0.5 points]
r
e. Substituting B = r, D = 1−ρ+r , and A = 0 into the guess for consumption and
the capital accumulation equation yields
r
Ct = rKt + zt .
1−ρ+r
1−ρ
Kt+1 = Kt + zt . [0.5 points]
1−ρ+r
Suppose with no loss of generality that εt = zt = 0 before the shock hits. In
period t, there is a one-time positive realization of εt = 1 − ρ + r. From period
t + 1 onward, εt = 0 again.
Capital Kt is predetermined and hence is not affected. The change in output in
period t is
∆Yt = r∆Kt + ∆zt = 0 + (1 − ρ + r).
The change in consumption in period t is given by
r r
∆Ct = r∆Kt + ∆zt = 0 + (1 − ρ + r) = r.
1−ρ+r 1−ρ+r
In period t + 1, εt+1 = 0, but zt+1 is not zero due to the autoregressive term
4
We can now infer the patern. Following the one-time shock, consumption rises
by r and stays at this new level for ever. In addition, n periods after the shock
the change in output is
∆Yt+n = r + ρn (1 − ρ),
and the change in the capital stock is
∆Kt+n = (1 − ρ)n .
The dynamics of output and capital depend on the persistence ρ of the tech-
nology shock. In the special case where ρ = 0, ie no persistence, there are no
further dynamics after period t + 1. In the period after the shock, and in all
those thereafter, capital is higher by one and and output is higher by r. [0.5
points]